Wednesday, November 20, 2013
7:54:28 PM EDT

Taper Talk Back On

by
Keene Little

The Fed's FOMC minutes brings the taper talk back on the table, leaving the market as confused as ever about what the Fed is likely to do over the next few months.

Market Stats

The market has been holding up well since the November 7th low and looked like we were ready for another leg up as we headed into this afternoon's release of the FOMC minutes. Instead the market was disappointed, if not confused, with the Fed's apparent turnaround with the taper talk back on the table. This afternoon's selloff left us with a bearish taste in our mouths. But there is still a chance the bulls will give us at least one more leg up to complete the rally from the November 7th low. They just need to start it immediately on Thursday.

Tuesday morning Bernanke had said the Fed will maintain its accommodative policy known as ZIRP (Zero Interest Rate Policy) for as long as needed and is now saying an unemployment rate below 6.5% would not necessarily kick in higher Fed rates. He stated their QE efforts, through asset purchases, would not begin to taper off until the Fed is assured the labor market improvements would continue. While believing significant progress has been made by the economy the Fed believes it is far from where they want it to be. All of this was interpreted by the market as a sign the Fed will keep both feet on the gas pedal and off the brake pedal. Interestingly the stock market did not react all that positively to his statements.

Perhaps the market is beginning (finally) to be worried that the Fed in fact is out of ammunition. Everything they've tried has not worked and just doing more of the same is only getting the Fed (the private banks) further into debt and the banks are massively leveraged at the moment. In many respects the banking system is much weaker today than it was in 2007. And if the Fed can't revive the economy with all that it has done, what is to happen with all of their debt and the leveraged assets owned by the banks? The Fed would be the next one looking for a bailout by the U.S. government to help it deal with its $4T in debt. If interest rates start rising sooner rather than later it's going to drastically decrease the value of the Fed's bond holdings.

It is this worry that will ultimately turn into fear and that will be what prompts the next stock market decline, and the decline will instill even more fear because it will show the Fed as completely incompetent and ineffectual. Their great financial experiment will go bust and market sentiment will quickly sour. Sentiment is the only reason the stock market is back into bubble territory and just like all bubbles, once the bullish momentum is lost it's usually a quick trip back down.

One way to measure the strength of the current rally is to look at the percentage of momentum movement (Momentum % on TDA's Prophet charts). The monthly chart below shows the indicator against the highs since 2000 and you can see how the momentum indicator clearly predicted trouble for the rally at the 2000 and 2007 highs. We've now got the same bearish divergence at the current high. This is clearly not a market timing tool but only one of many telling us the upside is probably limited.

SPX vs. Momentum %, 1994-present

The market was looking like we were going to get another leg up for the rally from November 7th but this afternoon's release of the FOMC minutes was a sucker punch to the bulls. Following the Fed's retraction of the taper talk back in September most have believed the Fed will not do anything until at least March 2014, with perhaps a discussion about it in December's meeting. They were surprised to hear the Fed is actively talking about tapering again and we've got a continuation of the Fed's miscommunication with the market, which is only increasing the market's frustration with the Fed's inability to affect anything and now only confusing everyone with their yo-yo responses.

Between Yellen's testimony last week and recent comments from Bernanke there's been an effort to let the market know the Fed will remain super accommodative until it sees further evidence of economic improvement. The only guessing recently has been on the timing of the next taper talk, which most believed will not come until next March. The ZIRP is expected to remain in place until at least 2015. There is no talk of potentially raising rates next year. The Fed has been attempting to make it clear that their ZIRP and their asset purchase program (QE) are two separate things and that relaxing their QE program (tapering their purchases) does not mean tightening. The market's reaction this afternoon says "I don't believe you."

The Fed is battling with mechanical rules (if unemployment drops to this, we do that), calendar dates and a limit on asset purchases vs. flexible rules for all of these. As they battle with how to do this (keep in mind that this is one grand experiment for them that's based only on theories that are debunked by many) they are confusing the markets with back and forth debate. It's not providing a sense of "they know what they're doing" and the uncertainty is what the market hates most. It's like following a guide into the woods on a long hike, assuming the guide knows where he's going, only to find out the guide is clueless, has no compass and the GPS batteries died. You're lost deep in the woods and getting ready to panic, fearing all the hungry bears around you and wondering why you ever trusted this yahoo to begin with.

There's now talk about tapering asset purchases without complete evidence of an improving economy while discussing other ways to entice banks to lend more money, such as stopping interest payments to banks who have deposits with the Fed. They keep pushing the supply side of the equation without realizing the demand side is missing. And these are Nobel-prize-winning economists!

The bottom line is that it appears the Fed is desperately looking for ways to stay accommodative while looking for ways to taper their asset purchases. They've successfully boxed themselves into a corner and now they're wondering how to get out. Many in the market realize we're in another asset bubble and worried that the Fed might not be able to keep it inflated. The web they've woven is starting to tear.

The good news for the Fed is the inflation picture. The bad news for the Fed is the inflation picture. One of the Fed's metrics, in helping to determine when enough is enough and to back off on asset purchases (creating money to do them) is inflation. For a long time their goal has been 2% inflation and have said they would move toward less accommodative if inflation started to worry them. Yesterday's report on CPI, showing 0% for October (+0.1% for Core CPI), gives them plenty of wiggle room to stay accommodative. That should have been market positive but it wasn't.

Perhaps the market is now becoming more worried about the fact that inflation has been budged higher even with the massive accommodation efforts by the Fed. It's another example of the market being much more powerful than even our mighty Fed. In fact, as the chart below shows, DEflation appears to be raising its "ugly" head again. I put ugly in quotes because deflation is like kryptonite to SuperFed -- it makes them quiver in their boots and fearful of a meltdown in the financial world as they know it. Deflation is actually a healthy cycle to go through as it helps clean out the debris, similar to a controlled burn in a forest, so that the markets become stronger overall.

But deflation is bad for borrowers because the value of the dollar increases and that increases the value of debt. Inflation decreases the value of debt over time and that helps the government. The chart shows the inflation rate down near the level it was in the early 1960s. Only the brief deflationary period in 2008-2009 saw the rate lower. It would appear that's where we're headed again, despite the enormous effort by the Fed to prevent it from happening. What's left in their arsenal to stop it?

With all the recent talk about how bullish the stock market is, and how it's expected to head higher into the end of the year. This has the retail trader feeling bullish, listening to the statistic that a market that is up at least +10% through October has a good chance of being another +6% higher into the end of the year. The CNBC cheerleaders have been out in force describing how bullish the market is and it's worked to get the retail investors pouring money into stock funds. In October the amount of money that flowed into equity mutual funds was the largest amount seen since April 2000. That was not a good time to be buying the stock market and I suspect neither is it a good time now. When everyone expects something (year-end rally), the market rarely accommodates them.

Before this afternoon's FOMC I was expecting another leg up to finish the rally tomorrow or by the end of the week. But based on this afternoon's selloff I'm now thinking we might have seen the final high on Monday. That would be fitting considering we had a full moon on Sunday and a quick high Monday morning fit well for a turn. Here's how my highly sophisticated (not to mention proprietary) Moon Phase Trading System (MPTS) looks:

SPX MPTS daily chart

In hindsight we'll know how well the latest full moon marked a high but considering the plethora of warning signals I think it deserves attention. But as I already mentioned, we had a good setup coming into this afternoon for at least a minor new high before completing the rally and while the afternoon selloff dented that expectation it hasn't punctured it yet.

Starting off with the DOW's charts tonight, the weekly chart shows how close it is to what should be strong resistance -- the trend line along the highs from 2000-2007, currently near 16150 and only about 120 points above Monday's high. A trend line drawn across the weekly closing highs since May crosses the 2000-2007 trend line this week, giving us another reason to suspect it could be resistance if tested. There is further upside potential to the 16700 area, as I've discussed previously, but at the moment I do not believe it will get there.

Dow Industrials, INDU, Weekly chart

A closer view shows the uptrend line from October 9th, which was tested with this afternoon's selloff. Currently near 15900, it will be important for the bulls to hold this line. A trend line along the highs from October 30 - November 18 crosses the 2000-2007 trend line Monday, near 16150. But another test of the trend line along the highs from May 2011 - August 2013, which stopped Monday's rally, is currently near 16045 so that would be another resistance level to watch if tested. A continuation of the selling on Thursday would turn the pattern more bearish but would not be confirmed bearish until it breaks below the November 13th low at 15672.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 15,800
- bearish below 15,672

To match up the DOW with the other indexes I'm using the November 7th low as the completion of the correction off the October 30th high. If we're to get a 5-wave move up from November 7th we need one more leg up. As labeled on its 60-min chart below, this afternoon's decline could have completed an a-b-c pullback from Monday, to complete the 4th wave in the move up from November 7th, which leaves one more leg up to complete the move. The 5th wave would equal the 1st wave at 16077, somewhat in between the trend lines mentioned above. This would be a very nice setup for the bears and then we'd have to see what kind of pullback/decline developed to help determine whether we're going to get just a larger pullback or something more bearish. But if the bulls don't step back in right away Thursday morning the first sign of serious trouble for the bulls would be a drop below the November 11th high at 15791 and confirmed bearish below the November 13th low at 15672.

Dow Industrials, INDU, 60-min chart

SPX has the same pattern as the DOW, which also requires an immediate rally on Thursday to save the bullish pattern that calls for one more new high before letting the bears tear into this thing. The November 11th high is near 1773 and today's low was 1777, so only 4 points before it would negate the bullish wave count (at that point the 4th wave would overlap the 1st wave in the move up from November 7th, which is an EW rule no-no in an impulsive rally). Confirmation of trouble for the bulls would be a drop below the November 13th low near 1760. Its 20-dma is located near 1772 on Thursday and a break below that would also be bearish (the 20-dma supported the decline into the November 7th and 13th lows). If the bulls can give us one more leg up I have upside targets pointing to 1804 and 1809 for a final high.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1780
- bearish below 1760

One of the reasons why I've been cautioning against an expectation for another new high is because of the rising wedge pattern for the rally from August. For a true wedge pattern we should see a corrective wave structure for each of the 5 waves inside it. That means the move up from November 7th should be a 3-wave move, which it currently is (more easily seen on the 60-min chart below). It did a little throw-over above the top of the wedge Monday morning and then collapsed back inside the wedge, creating a sell signal. On the daily chart above you can see how it also did a little throw-over above the top of the parallel up-channel from 2009, currently near 1786, and closed back below it today. That's another sell signal. This afternoon's decline broke and closed below the bottom of its wedge pattern, which is the uptrend line from October 9th. The November 13th low held this uptrend line so today's break is important. A 1-day break is recoverable but if it stays below the line, especially after a back test, it stays bearish.

S&P 500, SPX, 60-min chart

The pullback in NDX has already dropped it below its November 11th high, leaving the rally from November 7th a 3-wave move and potentially complete. It's back down to price-level support near 1367 but after breaking its uptrend line from October 9th and then back-testing it this morning it's not looking good for the bulls here. A drop below its November 13th low near 3346 would confirm we've seen the top, at least for now.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 3430
- bearish below 3346

The November 18th high for the RUT looks to have been a truncated finish to its rally. It was unable to climb above its October 30th high at 1123.26 and instead stalled at the 1119.49 projection where the rally from March 2009 has two equal legs up (Monday's high was 1119.98). The truncated finish, if in fact the rally is done, shows considerable weakness in the small caps and if the market is ready for at least a larger pullback we'll likely see the RUT lead the way down. There is also a significant bearish divergence at Monday's high, which makes the current setup look like a bearish double top. This afternoon's low hit its uptrend line from October 9th and bounced a little into the close. It might be good for at least a higher bounce but any bounce followed by a drop below today's low at 1096.46 would be a stronger sell signal.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 1120
- bearish below 1095

There's not a lot to go on with many of the other indexes, which leave me with mixed signals tonight. Some support higher prices while others suggest lower from here. The TRAN is in a similar position (could go either way for the rest of the week) and keeping an eye it for clues, especially as it relates to the DOW, should provide us some better information about what the broader market will do. The break of its uptrend line from October 9th today looks bearish. But it's holding its 20-dma (tested this afternoon at its low at 7077) and so far that's bullish. It reached its price projection at 7157, where the 3rd leg of its rally from October 2011 is 162% of the 1st leg, but has now turned back down and that's bearish. But it has another projection at 7444, where the rally from 2009 would have two equal legs up so that's bullish potential. A drop below its November 8th low at 6938 would be confirmed bearish but there's no confirmation yet that we'll see that happen.

Transportation Index, TRAN, Weekly chart

The dollar has been pulling back from its November 8th high in a choppy pattern, which supports the bullish pattern calling for another rally leg. I show on its chart a deeper pullback (to relieve more of the overbought condition on the daily chart) to retest its H&S neckline, near 76.68 by the beginning of December before heading higher again, but with today's bullish engulfing candlestick we might see it head higher right from here. It came close to testing its 20-dma, near 80.52, with this morning's low at 80.56, which is now crossing up through its 50-dma at 80.43. The dollar got a strong spike up this morning on news about what Bernanke was saying (alluding to less money printing ahead) and then another boost higher following the FOMC minutes. If the Fed starts back tracking ("well, uh, what we meant to say is, well, mmm, you know, it's like, you know, maybe we won't taper but we could sooner rather later if, you know, we decide to do it) the dollar could still get another leg down before starting its next rally leg. Regardless, I see higher for the dollar.

U.S. Dollar contract, DX, Daily chart

Last week, on November 12th, gold briefly broke support at its uptrend line from June-October but recovered the next day, which gave gold bulls a chance to make something of support holding. Unfortunately gold could not find enough bulls and the price has once again broken the uptrend line. With deflation rearing its ugly head again, the break below the November 12th low at 1260.50 confirms the breakdown. A drop below the October 15th low at 1251 keeps the bearish wave count intact, which calls for a decline down to at least the 1155 area if not lower toward 1050 in early 2014 before finding a more significant bottom. If you're looking to pick up some gold and silver I think we'll have a "golden" opportunity in early 2014.

Gold continuous contract, GC, Daily chart

Oil has now dropped down closer to its uptrend line from June 2012, currently near 92, which I would expect to hold as support. In addition to the uptrend line there is the 200-week MA at 91.82, which supported the decline into the April low (brief break below it but then the start of the rally into August). I show an expectation for a higher bounce but then lower early next year, looking for a drop down to at least the uptrend line from October 2011 - June 2012, currently near 82.

Oil continuous contract, CL, Daily chart

Following today's lower-than-expected CPI numbers we'll get the PPI numbers tomorrow. The Philly Fed index is expected to show a slowdown and we're probably getting to the point where poorer economic numbers are going to become more worrisome to the market now that the Fed is already hinting it could start to back off on bond purchases. But all reports will still be filtered through the expected Fed reaction, making it difficult to judge how the market will react.

Economic reports and Summary

I see a little more upside potential for the market but it's getting close to giving the all-clear signal to the bears. Some indexes, such as the techs and small caps, have already given off stronger sell signals but the blue chips are still holding on. An immediate rally on Thursday will keep the potential for a new high alive but use a new high as an opportunity to look for a reversal to short. A new high should be followed by at least a larger pullback to correct the rally from August and has the potential to start something a lot more bearish.

With most of the market believing the stock market is going to rally into the end of the year, finishing with the Santa Claus rally, it begs the question about whether there are too many now expecting this to happen. We all know the market doesn't like to do what most expect. I think we're in the topping zone and bears should start looking for their next meal. Bulls need to get very defensive here -- upside potential is dwarfed by downside risk.

Good luck and I'll be back with you next Wednesday.

Keene H. Little, CMT

In the end everything works out and if it doesn't work out, it is not the end. Old Indian Saying